Assume Daewoo, a hypothetical oil extraction company, has the following cost structure. It spends:
• $40/barrel on labor costs, raw materials, energy, and • $35/barrel on interest, depreciation, insurance, and administrative staff expense.
Read the textbook carefully, and answer the following questions.
A recession hits, the market price of crude oil falls to $50 per barrel, and the profitability takes a hit. Should Daewoo keep running the mine? -Yes, they should keep running the mine. I would say that Daewoo is a capital-intensive company based on the given information. The variable costs for Daewoo are $40 and the fixed costs are $35. Whenever the market price for our oil is greater than the variable costs, they should run the mine. Since the market price of crude oil is now $50 per barrel, I would still recommend them to run the mine and keep producing. Even though $50 per barrel is not enough to cover all the fixed costs, they still make $10 towards the fixed costs instead of zero dollars if they shut down. Because almost half of the cost price is fixed, there is little flexibility, but as long as the market price is above $40, they should keep operating.
Russia invades Ukraine, the market price shoots up well above $100 per barrel, and competitors announce new expansion plans. Should Daewoo add the new capacity? -Daewoo should not add capacity. When the market price shoots up like we see in this example, and at the same time competitors announce expansion plans, the best thing for Daewoo would be to stop adding capacity. The capital-intensive industry is prone to wide swings in profitability, which means that being aware of the industry cycle is critical. When the prices increase, and competitors start to expand, there is always a temptation to add capacity. If an expansion is not going to last three years, then the project will not contribute a lot, and the manager will wish he never added the new capacity at all. I do not expect the market price to be this high for three years, which means the expansion will not last this long either. Instead, Daewoo should enjoy the strong profits, sock away their cash, and wait for the over-expansion to play out. This is not easy to do, especially when you see competitors adding and adding capacity. You must remain calm and think contrarian.